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1
Money wealth• Supose the European Central Bank gives
youmillion. Your wealth has apparently increased.
• But what if you had received this money yearsago? Would your
euros be wealth then?
• Money is not wealth, but, at most and except forcurrency
collectors, a claim on wealth: money is aninstrument to acquire
wealth (goods) but notwealth itself (what if you were on a desert
island?).
• The purchasing power of an amount of money isthe amount of
goods that can be obtained from it.
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ey
2
Fallacy of composition• If you receive million, your
purchasing power(ability to obtain wealth) increases. If everyone
inSpain receives million, is Spain wealthier?
• The fallacy of composition holds that what is trueat a certain
scale (the individual level) need not betrue at a larger scale (the
group, or economy, level).
• A seller reducing prices may sell more products.But if every
seller reduces prices, it is not true thatall of them would sell
more products. If everybodyleaves home earlier to avoid a traffic
jam, the jam isno avoided but merely brought forward.
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ey
3
Banking crises, bubbles & the fallacy /1•
Banks extend loans with assets as collateral. If theborrower cannot
service the loan, the bank seizesthe asset (this occurs, for
instance, with mortgages).
• Suppose that loans are mainly used to finance thepurchase of
real estate. If many banks engage inthat lending, the prices of
real estate will tend torise. The expectation of higher prices may
attractmore real estate investors.
• More investors lead to a higher demand for loans,probably at a
higher interest. The banks would behappy to grant collateralizing
loans since the valueof the collateral (real estate) is
booming.
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4
Banking crises, bubbles & the fallacy /2•
As the entry of new investors slows down, thevalue of real state
tends to fall. This damages thelast round of investors. When they
fail to repay theloans, the banks’ lending becomes more
prudent.
• The credit contraction reduces the value of realstate further.
More default occurs. Banks turn riskadverse to lending. More
bankruptcies follow.When banks finally seize the collateral, it is
adepreciating asset that risks the banks’ solvency.
• The fallacy: when banks engaged in collateraliza‐tion, each
presumed that it does not affect the priceof the collateral asset.
This is false in the aggregate.
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5
Can too much money be harmful?
• For wealth, it appears that the more, the better.Does the same
apply to money?
• Intuition: if the amount of wealth grows at a ratesmaller than
the amount of money, in proportion,more money corresponds to each
unit of goods.
• This means that the money price of goods rise. Byhow much?
There can be no limit, as hyperin‐flations testify: in a
hyperinflation, the inflation rateis out of control (prices may
change every minute).
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6
trillion
http://stephenlaughlin.posterous.com/buy‐an‐100‐trillion‐zimbabwe‐dollar‐bank‐notehttp://en.wikipedia.org/wiki/Zimbabwean_dollar
http://online.wsj.com/news/articles/SB10001424052748703730804576314953091790360
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7
Largest denomination banknote
Hungary 1946 ∙ 100 quintillion ( = 1020
) pengőhttp://en.wikipedia.org/wiki/Hyperinflation
http://www.zimbabwesituation.com/nov14_2008.html#Z2
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8
Money as a sign of poverty
• Large denomination banknotes (the fuel that feedsthe flames of
hyperinflations) are actually a sign ofpoverty not wealth. In
Hungary, , pricesdoubled every hours (monthly inflationreached per
cent).
• The trillion banknote at some point incould just buy a bus
ticket. It circulated a few
months, until the was abandoned as legalcurrency in April . In
May , the note wasworth some : it had become a commodity(wealth)
for currency collectors and tourists.
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ey
9
0
2,5
5
7,5
10
12,5
15
17,5
20
22,5
25
27,5
30
32,5
35
37,5
40
42,5
45
47,5
50
52,5
55
57,5
60
1‐62
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1‐10
1‐11
1‐12
1‐13
Circulation of pesetas
(value, EUR billions)http://www.bde.es/webbde/es/estadis/infoest/series/be0716.csv
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10
Traditional account of money• Money is everything
considered money: money isas money does. It is recognized by three
functions.
• Medium of exchange. Goods can be generallyobtained in exchange
for money, that is, moneymust can be used to make purchases of
goods.
• Store of value. Money has the ability to preserve (atleast
part) of its purchasing power in time: it is away of accumulating
purchasing power.
• Unit of account. The value of goods is expressed interms of
money (the euro from to ).
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ey
11
Is there a most important function?•
Neoclassical economists tend to emphasize themedium of exchange
function. Money is a “veil”under which the “true” economy (real
sector) ope‐rates. Money just facilitates the exchange of
goods.
• Postkeynesians put the emphasis on money asstore of value. The
ability to store wealth liesbehind the existence and persistence of
the unequaldistribution of wealth.
• Historical evidence points to money as quantifiedreminders of
debts, so money served as mere unitof account (D. Graeber ( ):
Debt. The first years).
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ey
12
The textbook myth /1• Textbooks typically explain
the story of the pro‐gression from barter to currency (gold and
silvercoinage) to credit. The historical evidence suggeststhat
things have occurred the other way round.
• Records from Ancient Egypt and Mesopotamia (ca.) show that the
development of a credit
system preceded the invention of coinage.
• In Ancient Mesopotamia, prices and debts (rents,fees, loans)
were calculated in silver but had not bepaid in silver. Peasants
settled their debts mostly inbarley and most transactions were
based on credit.
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13
The textbook myth /2
• So “virtual money” was first. Coins came muchlater, but were
unable to completely replace creditsystems.
• Barter is a kind of accidental byproduct of the useof coinage
or paper money.
• Most of the cases of barter that are known, involvepeople are
familiar with the use of money but, forone reason or another, have
no access to currency(shortage of in Argentina, , or rubles
inRussia, in the s).
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ey
14
The credit theory of money• Holds that money
is not a commodity (a “thing”)but an accounting tool. Money is a
yardstick thatmeasures debt (the same thing as credit). Coins
andbanknotes are a promise to pay something (see 15).
• Popular traditional perception: money derived itsvalue from
the precious metals of which the coinswere made.
• Credit theory: a sale and purchase is the exchangeof a
commodity for credit, so the value of credit ormoney does not
depend on the value of any metalor metals, but on the right to get
the credit satisfied.
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15http://commons.wikimedia.org/wiki/File:Spain‐franco_bank_notes_0009.jpg
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16
The commodity theory of money• Holds that
money is a commodity whose role is tomake trade easier. The point
is to find the mostconvenient commodity to perform that
function:one that is durable, easily recognized, divisible,easy to
transport… The choice eventually narro‐wed down to the metals
(http://mises.org/daily/6122/)
• As with any other commodity, an “excessive”amount of money
tends to lower its value. Moremoney should be given for goods, so
the prices ofgoods are pushed up. The policy recommendationis to
limit the amount of money in circulation.
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ey
17
Fiat money fiat currency (notes)• Money
could be defined as anything generallyaccepted as a payment (in
exchange) for goods. Butmoney is accepted for goods because of the
beliefthat it will be subsequently accepted for goods.
• The popular view identifies money with currency( “physical
money” coins & banknotes), whichwhat is typically used to buy
goods. In the past,currency had intrinsic value (were pieces of
metal).
• Currency is now fiat money: intrinsically worthlesspieces of
paper or metal. More generally, “money”is “legal tender fiat
currency originated by a centralbank, the printed version of which
is ‘cash’”.
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18
Modern monetary theory• “Also known as neochartalism,
[it] is a descriptiveeconomic theory that details the procedures
andconsequences of using government‐issued tokensas the unit of
money, i.e., fiat money”.
• “MMT aims to describe and analyze moderneconomies in which the
national currency is fiatmoney, established and created exclusively
by thegovernment. In MMT, money enters circulationthrough
government spending. Taxation and itsLegal Tender power to
discharge debt establish thefiat money as currency”.
http://en.wikipedia.org/wiki/Modern_Monetary_Theory
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19
Our currency: the euro• The euro (sign: ; code: )
is the official curren‐cy of the members of the eurozone
(officiallycalled euro area): A, B, C, E, FI, FR, GE, GR, IR,
IT,LA, LU, M, N, P, SLA, SLE, and SP.
• The euro was born in Jan. as a unit of accountand became
currency on Jan. . It is managedby the Eurosystem: the European
Central Bankplus the central banks of the eurozone members.
• It is the second most traded currency in the world,after the .
By mid‐ , it surpassed the asthe currency with highest value in
circulation.
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20
http://en.wikipedia.org/wiki/File:Eurozone.svg
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2013
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1cCirculation of euro coins (% share, quantity)http://www.ecb.europa.eu/stats/euro/circulation/html/index.en.html
5c
10c
20c50c
€2 €1
2c
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Circulation of euro coins
(% share, value)
http://www.ecb.europa.eu/stats/euro/circulation/html/index.en.html
€2
50c
20c
10c
1c2c5c
€1
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23
0
2000
4000
6000
8000
10000
12000
14000
16000
18000
20000
22000
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26000
28000
2002
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1c
2c
5c
10c
20c
50c
€1
€2
Circulation of euro coins (quantity, millions)http://www.ecb.europa.eu/stats/euro/circulation/html/index.en.html
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24
Circulation of euro coins
Eurozone (changing composition) ∙ Dec 2013
Low denomi-nation coins
Quantity(millions)
High denomi-nation coins
Quantity(millions)
1 CENT 27,675 26.1%
20 CENT 9,7569.2%
2 CENT 21,620 20.4%
50 CENT 5,4325.1%
5 CENT 17,14416.2%
1 EUR 6,5136.1%
1o CENT 12,72412%
2 EUR 5,0944.8%
http://www.ecb.europa.eu/stats/euro/circulation/html/index.en.htm
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25
0
500
1000
1500
2000
2500
3000
3500
4000
4500
5000
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6500
7000
7500
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8500
9000
9500
10000
10500
11000
2002
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‐7
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‐1
2013
‐7
Circulation of euro coins
(value, EUR millions)http://www.ecb.europa.eu/stats/euro/circulation/html/index.en.html
€2
€1
50c
20c
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26
Circulation of euro coins
Eurozone (changing composition) ∙ Dec 2013
Low denomi-nation coins
Value(EUR millions)
High denomi-nation coins
Value(EUR millions)
1 CENT 2771.1%
20 CENT 1,9518.1%
2 CENT 4321.8%
50 CENT 2,71611.2%
5 CENT 8573.5%
1 EUR 6,51326.9%
1o CENT 1,2725.3%
2 EUR 10,189 42.1%
http://www.ecb.europa.eu/stats/euro/circulation/html/index.en.htm
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‐1
2013
‐7
Circulation of euro banknotes
(quantity, millions)http://www.ecb.europa.eu/stats/euro/circulation/html/index.en.html
€200
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Mon
ey
28
020406080
100120140160180200220240260280300320340360380400420440460480500520540560580600620
2002
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‐7
Circulation of euro banknotes
(quantity, millions)http://www.ecb.europa.eu/stats/euro/circulation/html/index.en.html
€200
€500
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29
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‐1
2010
‐7
2011
‐1
2011
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‐1
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‐1
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‐7
€200
€500
€5
Circulation of euro banknotes
(quantity, millions)http://www.ecb.europa.eu/stats/euro/circulation/html/index.en.html
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30
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‐1
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‐7
Circulation of euro banknotes
(quantity, millions)http://www.ecb.europa.eu/stats/euro/circulation/html/index.en.html
€200
€500
€5
€100
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Mon
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31
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2200
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‐1
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€200
€500
€100
€10
€5
Circulation of euro banknotes(quantity, millions)
http://www.ecb.europa.eu/stats/euro/circulation/html/index.en.html
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Mon
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32
0
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Circulation of euro banknotes
(quantity, millions)http://www.ecb.europa.eu/stats/euro/circulation/html/index.en.html
€200
€100
€10
€20
€5
€500
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0
500
1000
1500
2000
2500
3000
3500
4000
4500
5000
5500
6000
6500
7000
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‐1
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‐1
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‐7
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‐1
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‐7
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‐1
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‐7
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‐7
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‐1
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‐7
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‐1
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‐7
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‐1
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‐7
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‐1
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‐7
Circulation of euro banknotes
(quantity, millions)http://www.ecb.europa.eu/stats/euro/circulation/html/index.en.html
€10
€20
€50
€5 €500€100€200
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Circulation of euro banknotes
Eurozone (changing composition) ∙ Dec 2013
Low deno-mination
Quantity(millions)
High deno-mination
Quantity(millions)
5 1,672 10.1% 100 1,850 11.2%
10 2,156 13.1% 200 199 1.2%
20 3,089 18.7% 500 583 3.5%
50 6,963 42.2% TOTAL 16,512
http://www.ecb.europa.eu/stats/euro/circulation/html/index.en.htm
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‐1
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‐7
Circulation of euro banknotes
(% share of total banknotes)http://www.ecb.europa.eu/stats/euro/circulation/html/index.en.html
€500
€20
€50
€10€5
€200
€100
-
Mon
ey
36
0
2
4
6
8
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12
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16
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30
32
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36
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44
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Low denomination euro banknotes
(% share ∙ Quantity & value)http://www.ecb.europa.eu/stats/euro/circulation/html/index.en.html
V €20
V €10
V €50
Q €20
Q €50
Q €10Q €5
V €5
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37
0
2
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36
38
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‐1
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‐7
High denomination euro banknotes
(% share ∙ Quantity & value)http://www.ecb.europa.eu/stats/euro/circulation/html/index.en.html
Q €100
Q €200Q €500
V €100
V €200
V €500
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Mon
ey
38
0
25
50
75
100
125
150
175
200
225
250
275
300
325
350
2002
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2010
‐1
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‐7
2011
‐1
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‐7
2012
‐1
2012
‐7
2013
‐1
2013
‐7
Circulation of euro banknotes
(value, EUR billions)http://www.ecb.europa.eu/stats/euro/circulation/html/index.en.html
€500
€100
€200
€50
€20€10
€5
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39
Circulation of euro banknotes
Eurozone (changing composition) ∙ Dec 2013
Low deno-mination
Value(EUR billions)
High deno-mination
Value(EUR billions)
5 8.4 0.9% 100 185 19.3%
10 21.6 2.3% 200 39.8 4.2%
20 61.8 6.5% 500 291.6 30.5%
50 348.1 36.4% TOTAL 956.2
http://www.ecb.europa.eu/stats/euro/circulation/html/index.en.htm
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0
0,005
0,01
0,015
0,02
0,025
0
50
100
150
200
250
300
350
400
450
500
550
600
650
700
750
800
850
900
950
1000
2002
‐1
2002
‐7
2003
‐1
2003
‐7
2004
‐1
2004
‐7
2005
‐1
2005
‐7
2006
‐1
2006
‐7
2007
‐1
2007
‐7
2008
‐1
2008
‐7
2009
‐1
2009
‐7
2010
‐1
2010
‐7
2011
‐1
2011
‐7
2012
‐1
2012
‐7
2013
‐1
2013
‐7
BANKNOTES
COINS(rightscale)
Circulation of euro banknotes & coins
(value, EUR billions)http://www.ecb.europa.eu/stats/euro/circulation/html/index.en.html
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Circulation of euro banknotes (SPA)
Net circulation (issued
returned) ∙ Dec 2013
Low deno-mination
Quantity(millions)
High deno-mination
Quantity(millions)
5 79 100 2410 840 200 1320 1,132 500 81
50 862 Pesetas (EUR millions)
806
http://www.bde.es/webbde/es/estadis/infoest/bolest7.html
41
-
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ey
42
020406080
100120140160180200220240260280300320340360380400420440460480500520540560580600620
2002
‐1
2002
‐7
2003
‐1
2003
‐7
2004
‐1
2004
‐7
2005
‐1
2005
‐7
2006
‐1
2006
‐7
2007
‐1
2007
‐7
2008
‐1
2008
‐7
2009
‐1
2009
‐7
2010
‐1
2010
‐7
2011
‐1
2011
‐7
2012
‐1
2012
‐7
2013
‐1
2013
‐7
Circulation of banknotes, Eurozone & Spain (value, EUR billions)http://www.ecb.europa.eu/stats/euro/circulation/html/index.en.html
http://www.bde.es/webbde/es/estadis/infoest/series/be0716.csv
SPAIN
EUROZONE
-
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ey
43
0
5
10
15
20
25
30
35
40
45
50
55
60
65
70
75
80
85
90
2002
‐1
2002
‐7
2003
‐1
2003
‐7
2004
‐1
2004
‐7
2005
‐1
2005
‐7
2006
‐1
2006
‐7
2007
‐1
2007
‐7
2008
‐1
2008
‐7
2009
‐1
2009
‐7
2010
‐1
2010
‐7
2011
‐1
2011
‐7
2012
‐1
2012
‐7
2013
‐1
2013
‐7
TOTAL VALUE
€50
€500
Circulation of banknotes, Spain (value, EUR billions)http://www.bde.es/webbde/es/estadis/infoest/series/be0716.csv
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ey
44
‐25
‐20
‐15
‐10
‐5
0
5
10
15
20
25
30
35
40
45
50
55
60
65
70
75
80
85
90
2002
‐1
2002
‐7
2003
‐1
2003
‐7
2004
‐1
2004
‐7
2005
‐1
2005
‐7
2006
‐1
2006
‐7
2007
‐1
2007
‐7
2008
‐1
2008
‐7
2009
‐1
2009
‐7
2010
‐1
2010
‐7
2011
‐1
2011
‐7
2012
‐1
2012
‐7
2013
‐1
2013
‐7
TOTAL VALUE
Circulation of banknotes, Spain (value, EUR billions)http://www.bde.es/webbde/es/estadis/infoest/series/be0716.csv
€50
€20
€500
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ey
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Monetary aggregates
• Monetary aggregates are technical ways of defining(measuring
the amount of) money.
= monetary base = high‐powered money = = currency held by the
public (cash) = bank reserves = currency in bank vaults thebanks’
deposits at the central bank
(money stock/supply, monetary mass) = deposits =
non‐interest‐bearing accounts at banks
savings depositstime deposits others
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ey
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Technical definitions of money (ECB)• “ : a
narrow monetary aggregate that com‐prises currency in circulation
[banknotes andcoins] plus overnight deposits held with s[monetary
financial institutions] and centralgovernment (e.g. at the post
office or treasury).”
• “ : an intermediate monetary aggregate thatcomprises plus
deposits redeemable at aperiod of notice of up to and including
months(i.e. short‐term savings deposits) and depositswith an agreed
maturity of up to and includingyears (i.e. short‐term time
deposits) held withs and central government.”
-
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ey
47
Technical definitions of money (ECB)
• “ is a broad monetary aggregate that com‐prises plus
marketable instruments, inparticular repurchase agreements,
moneymarket fund shares and units, and debtsecurities with a
maturity of up to and includingtwo years issued by s”.
• “These aggregates differ with regard to thedegree of moneyness
of the assets included”.
http://www.ecb.europa.eu/pub/mb/html/index.en.htmlhttp://www.ecb.europa.eu/pub/pdf/mobu/mb201401en.pdf
ECB Monthly Bulletin (glossary)
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http://www.ecb.europa.eu/stats/money/aggregates/aggr/html/hist.en.html
Technical definitions of money (ECB)
overnight deposits
balances which can immediately be converted into currency or used for cashless payment
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ey
49
0
0,5
1
1,5
2
2,5
3
3,5
4
4,5
5
5,5
2013
Dec
2012
Dec
2011
Dec
2010
Dec
2009
Dec
2008
Dec
2007
Dec
2006
Dec
2005
Dec
2004
Dec
2003
Dec
2002
Dec
2001
Dec
2000
Dec
1999
Dec
1998
Dec
1997
Dec
1996
Dec
1995
Dec
1994
Dec
1993
Dec
1992
Dec
1991
Dec
1990
Dec
1989
Dec
1988
Dec
1987
Dec
1986
Dec
1985
Dec
1984
Dec
1983
Dec
1982
Dec
1981
Dec
1980
Dec
CURRENCY
Eurozone (EUR trillions, working day and seasonally adjusted)http://sdw.ecb.europa.eu/browse.do?node=2120791
M1
OVERNIGHTDEPOSITS
-
Mon
ey
50
0
0,5
1
1,5
2
2,5
3
3,5
4
4,5
5
5,5
6
6,5
7
7,5
8
8,5
9
9,5
2013
Dec
2012
Dec
2011
Dec
2010
Dec
2009
Dec
2008
Dec
2007
Dec
2006
Dec
2005
Dec
2004
Dec
2003
Dec
2002
Dec
2001
Dec
2000
Dec
1999
Dec
1998
Dec
1997
Dec
1996
Dec
1995
Dec
1994
Dec
1993
Dec
1992
Dec
1991
Dec
1990
Dec
1989
Dec
1988
Dec
1987
Dec
1986
Dec
1985
Dec
1984
Dec
1983
Dec
1982
Dec
1981
Dec
1980
Dec
DEPOSITSUP TO 2 YEARS
Eurozone (EUR trillions, working day and seasonally adjusted)http://sdw.ecb.europa.eu/browse.do?node=2120791
M1
M2
REDEEMABLEDEPOSITS
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ey
51
0
1
2
3
4
5
6
7
8
9
10
2013
Dec
2012
Dec
2011
Dec
2010
Dec
2009
Dec
2008
Dec
2007
Dec
2006
Dec
2005
Dec
2004
Dec
2003
Dec
2002
Dec
2001
Dec
2000
Dec
1999
Dec
1998
Dec
1997
Dec
1996
Dec
1995
Dec
1994
Dec
1993
Dec
1992
Dec
1991
Dec
1990
Dec
1989
Dec
1988
Dec
1987
Dec
1986
Dec
1985
Dec
1984
Dec
1983
Dec
1982
Dec
1981
Dec
1980
Dec
M2
M1
M3Eurozone (EUR trillions, working day and seasonally adjusted)http://sdw.ecb.europa.eu/browse.do?node=2120791
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ey
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0
0,5
1
1,5
2
2,5
3
3,5
4
4,5
5
5,5
2013
Dec
2012
Dec
2011
Dec
2010
Dec
2009
Dec
2008
Dec
2007
Dec
2006
Dec
2005
Dec
2004
Dec
2003
Dec
2002
Dec
2001
Dec
2000
Dec
1999
Dec
1998
Dec
1997
Dec
1996
Dec
1995
Dec
1994
Dec
1993
Dec
1992
Dec
1991
Dec
1990
Dec
1989
Dec
1988
Dec
1987
Dec
1986
Dec
1985
Dec
1984
Dec
1983
Dec
1982
Dec
1981
Dec
1980
Dec
M2‐M1
M1
M3‐M2
Eurozone (EUR trillions, working day and seasonally adjusted)http://sdw.ecb.europa.eu/browse.do?node=2120791
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‐1,5
‐1
‐0,5
0
0,5
1
1,5
2
2,5
3
3,5
4
4,5
5
5,5
6
6,5
7
2013
Dec
2012
Dec
2011
Dec
2010
Dec
2009
Dec
2008
Dec
2007
Dec
2006
Dec
2005
Dec
2004
Dec
2003
Dec
2002
Dec
2001
Dec
2000
Dec
1999
Dec
1998
Dec
1997
Dec
1996
Dec
1995
Dec
1994
Dec
1993
Dec
1992
Dec
1991
Dec
1990
Dec
1989
Dec
1988
Dec
1987
Dec
1986
Dec
1985
Dec
1984
Dec
1983
Dec
1982
Dec
1981
Dec
1980
Dec
M1
Eurozone (monthly rate of change, %)http://sdw.ecb.europa.eu/browse.do?node=2120791
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‐3
‐2
‐1
0
1
2
3
4
5
6
7
8
9
10
11
12
13
14
15
16
17
18
2013
Dec
2012
Dec
2011
Dec
2010
Dec
2009
Dec
2008
Dec
2007
Dec
2006
Dec
2005
Dec
2004
Dec
2003
Dec
2002
Dec
2001
Dec
2000
Dec
1999
Dec
1998
Dec
1997
Dec
1996
Dec
1995
Dec
1994
Dec
1993
Dec
1992
Dec
1991
Dec
1990
Dec
1989
Dec
1988
Dec
1987
Dec
1986
Dec
1985
Dec
1984
Dec
1983
Dec
1982
Dec
1981
Dec
M1
M2
M3
Eurozone (annual rate of change, %)http://sdw.ecb.europa.eu/browse.do?node=2120791
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The textbook model of money creation
• The cash reserve ratio is the amount ofreserves banks must
hold per euro of deposit. It isthe percent of deposits banks cannot
lend.
• The liquidity ratio is the amount ofcurrency that people hold
per euro of deposits.
• The money multiplier is .
• It then follows that , so .Hence, if remains constant, .
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The money multiplier
• Calling the money stock , the money multiplierindicates how
many units of money stock is
generated by one unit of monetary base.
• In fact, and imply. In addition, , , and
yield . In sum,
• Therefore, (the money stock) is a fixed multipleof (the
monetary base).
.
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Money creation process /1
• Suppose is increased by million. Forinstance, the central bank
buys financial assetsfrom the banks and pays by increasingmillion
the reserves of banks on the central bank.
• Since the deposits on banks have not changed,banks have an
excess of reserves equal to . Theycan then lend the million to
consumers andfirms. Let consumers and firms be always willingto
borrow any amount offered by banks.
• The people that borrow the million willspend them buying goods
or financial assets.
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Money creation process /2
• The sellers of the goods or the financial assets getmillion.
Let , so people hold
cents in cash for each euro deposited on banks.
• People must then allocate the million in cashand deposits to
make the increase in cashdivided by the increase in deposits equal
to .The equations giving the solution are and
or, equivalently, .
As a result, and .
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Money creation process /3
• This means that people deposit million onbanks and hold
million in cash. Suppose
. Hence, banks only need to keep as reservesthe of new deposits
and can lend the rest. Thefollowing table summarizes the process so
far.
• Now the process recommences: people borrow andspend , and
those receiving the keep a partin cash ( ) and deposit the rest ( )
on banks.
∆M0 ∆D ∆E ∆R ∆loans ∆D ∆R ∆M1 ∆E ∆D
1 600 600 600
2 500 100 50 450 600
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Money creation process /4
• The following table represents the process.
• Deposits grow continuously:In the limit, the sum converges to
.
∆M0 ∆D ∆E ∆R ∆loans ∆D ∆R ∆M1 ∆E ∆D1 600 600 6002 500 100 50 450
6003 375 75 37.5 337.5 4504 281.25 56.25 28.125 253.125 337.55
210.9.. 42.1... 210.9... 189.84... 253.125∙∙∙ ∙∙∙ ∙∙∙ ∙∙∙ ∙∙∙
∙∙∙
TOTAL 600 2,000 400 200 1,800 2,400
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Money creation process /5was initially increased
by . What fraction is
finally held in cash? The sum, which converges to .
• Since , . That is,. Thus, . This is also the
value to which the sumconverges (the at round should
not be counted because banks lend this amount:they represented
voluntary, not legal reserves).
yields . Asand , : an increase of in
is transformed into an increase of in .
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Money creation process /6
• This suggests that the money multiplier mustbe : generates .
In fact,
captures the total effect on the cash held by thepeople and the
deposits generated by the process
• This sequence illustrates the interaction betweenthe financial
side (deposits and loans) and the realside (purchases of
goods).
… deposits loans expenditures
revenues deposits loans …
.. .
.
..
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CentralBank Banks Consumers
Producers
600600loans
600purchases
E = 100
Banks Consumers450
R = 50
D = 500
Producers
450purchases
E = 75
Banks Consumers337.5
loans
R = 37.5
D = 375
loans
. . .
Summary of the textbook money creation process
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The reality of bank lending
• In the model, banks need to receive a deposit tolend. In
reality, when a bank makes a loan, themoney lent is not taken from
anyone’s account norfrom the bank’s funds: it is created out of
thin air.
• As deposits are accounting entries in a computer,the bank
creates the money by crediting its custo‐mer’s account with the
amount of the loan and ba‐lancing this liability by registering the
amount ofthe loan as an asset. The bank is not actually provi‐ding
cash but the promise to provide cash. But thatpromise, the account
at the bank, counts as cash.
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Banking system’s shaky foundations• Problem: the
banks promise to deliver somethingthat they cannot deliver, as
there is not enoughcash in an economy to cash all bank deposits. In
abank run a large number of customers decide towithdraw their
deposits simultaneously.
• In slide , deposits worth are created, butthey are backed by
only the additional in cash.
• In Spain, the Deposit Guarantee Fund of CreditInstitutions
guarantees up to per depositin case of bankruptcy. The fund ended
with ashortfall of billion. http://www.fgd.es/en/index.html
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Banking business: fraud & catastrophe
• 1/ Banking works as long as everyone believes itdoes. If
confidence is lost, the system collapsesbecause it relies on the
fiction of unexisting money.
• 2/ The creation of bank money (loans) rests only onthe bank’s
belief that the borrowers can repay.
• 3/ Nothing controls the scale/timing of bank len‐ding. Banks
lend freely until they fear a default onrepayments. New loans are
refused and economicactivity declines: lending, expenditure,
pro‐duction, employment,
lending.http://www.opendemocracy.net/ourkingdom/oliver‐huitson/uneconomics‐guide‐to‐money‐creation